The Bank of Canada decided today at their September meeting to keep rates as is, at 0.5%.
What is this interest rate, what’s it about, what does it mean?
This rate actually only applies directly to banks. The Bank of Canada sets this rate as the amount of interest banks may charge when they loan each other money. The banks then add a couple percentage points to that and call it the consumer rate = a 2.5% lending rate. This extra 2% is added because there are regulations in place for our big banks that stipulate how much capital, or money reserves, a bank must have at all times based on how much it is loaning out. This ensures that the bank can cover any defaulting loans and also means that our Canadian banking system is pretty air tight, particularly in comparison to that of our southern neighbour – though their regulators have asked the banks to carry more cash after that 2008 fiasco, likely not enough though to ensure protection…)
Why does it change though?
The interest rate is used as a stimulus effort. If an economy is struggling or sagging, as Canada’s currently is thanks in part to the sad state of oil prices (presently there is too much oil in the world and not enough demand and yet oil producing countries just keep on pumping it out), then the rate is adjusted to make money cheap to borrow. When money is cheap to borrow, theoretically it stimulates borrowing and therefore spending across business and consumer markets.
I’ve heard things about inflation, how are the two related?
By adjusting the interest rate, the Bank of Canada is effectively using monetary policy to drive our inflation rate towards the targeted rate.
What?
Monetary policy is the practice of the Bank of Canada to keep our economy in stable condition. The main indicator that the Bank uses to determine where we’re at is the rate of inflation. Most of us know inflation as the thing that determines how far a dollar will go, and this is exactly what it does. Inflation controls the purchasing power of money by either making things cost less or cost more. This is where the interest rate comes in to play; in pushing the inflation rate up by making money cheap to borrow, there is then technically more money in circulation which increases demand for the existing supply of goods, making the cost of goods higher – and your twenty dollar bill worth less. The ideal rate is 2%, which is viewed as the equilibrium point where economic growth meets a higher cost of living.
What happens if the inflation rate goes down?
This is called deflation. Deflation is the opposition of inflation: there is a lesser amount of demand (lesser amount of money circulating in the economy) but a greater supply of goods available, thereby increasing purchasing power and decreasing the overall cost of goods. This is as equally dangerous to an economy as over inflation because if prices fall too low, businesses can’t make profits and maintain operations, people lose jobs and then we see issues in other economic areas like housing, consumer spending, etc.
Recent real life example:
Price deflation is what has happened to oil globally. The demand has remained the same, yet oil production is in overdrive. With the product, oil, just sitting there not needed, prices have been driven down.
And that’s it. I hope this was helpful! Leave a comment and tell me what you think!
Feature image via Park & Cube.
